French pension system: steady as she blows!

When the ‘winds of change’ are blowing – most batten down the hatches to protect themselves. Some hoist the sails and take advantage of the change.

The existing French pension system was set up in a bygone era when circumstances were different. Change is afoot, the kind of change that requires a firm hand on the tiller. Problems can occur however when policy making is influenced by external forces, such as the ‘markets’ or the mood of the electorate, which are not easy to control. If the chosen course is not navigated correctly, the ruling party may find itself on a collision course.

The French government has recognized the need to protect the national pension system from its demographic imbalances so as to ensure that it remains financially sustainable. The pension reform bill, newly passed by France’s National Assembly and likely to be approved by the Senate, is a major step in addressing the shortfall in the nation’s mandatory, state-run pension system.

In order to keep a sinking ship buoyant it is necessary to bail out the water that is weighing it down. France’s growing budget deficit currently stands at 7.5 per cent of GDP, significantly above the 3 per cent target set by the EU. The new policy is designed to reduce the country’s pension costs and bring public borrowing down. It is forecast that measures undertaken by the reform would rein in the deficit to the tune of €70 billion by 2018 and bring the pension system back onto an even keel.

France has one of the world’s highest life expectancy rates with the most recent statistics revealing a lifespan of 77.8 for men and 84.5 for women. The problems associated with an ageing population are compounded when a country also has a falling birth rate. As a result, the dependency ratio of those aged 65 and over as a proportion to those aged 20-64 is expected to rise from the present figure of 25% to 50% by 2050. This means that as time goes by the onus will be on a dwindling number of working age people to support those in retirement. These demographic trends are putting tremendous pressure on the French pension system.

In order to put the PAYG pension system on a sounder financial footing it was necessary to consider the reform options and their likely consequences. The three choices open to policy makers were as follows:

To lower retirees’ pensions;

To increase compulsory contributions;

To raise the retirement age.

French pension system

The French government decided that the best way to respond to the demographic imbalances was to raise the retirement age and therein the number of years of contributions to the state-run system needed to receive a full pension. The new government policy increases the standard retirement age to 62 years from its current 60 and will raise the age of entitlement to a full pension to 67. This change will be phased in from now until 2018 with a four month increase in the legal retirement age per year. The reforms will require both men and women to have paid social security contributions for a minimum of 41.5 years, instead of the current 40, in order to qualify for a full pension. The objective is thus to have the contribution term increase in line with the rise in life expectancy, so that the ratio of ‘period of pension payment’ to the ‘working period’ remains constant.

Far away fields are not necessarily green

It is up to each individual country to decide which system is most suitable for its people, and how the system should be structured to cope with the changing demographic background and economic situation. There is always a trade off when reforming current systems between the prevention of pensioner poverty, and the ability of a state to honor the promises they make.

National retirement-income systems are complex with pension benefits depending on a wide range of factors. Differences in retirement ages, required years of service, benefit calculation methods and adjustment of paid-out pensions make it very difficult to compare pension systems. There are however a number of useful metrics that facilitate cross-country comparisons.

The replacement rate, which measures pension entitlements as a share of individual lifetime average earnings, amounts to50% in France. This is below the OECD rate which equates to 70% of earnings after tax. However, the French spend an average of 24.5 years in retirement, compared to 19.8 for other OECD countries.

France currently spends 12.4% of national income on public pension provision compared to the OECD average of 7.2%. This accounts for 23% of government expenditure in comparison to the OECD average of 16%. This obligation to provide retirement benefits over an extended retirement period has made the pension promise too expensive to maintain.

In 2007, Germany opted to gradually increase its standard retirement age to 67 from 65 in order to deal with the impact of an ageing population on its pension system. The Netherlands and Denmark have followed suit setting their retirement age at 67 by 2025, whereas Spain and Italy have recently increased their retirement age to 65. Meanwhile, the United Kingdom has pledged to raise its retirement age to 68 by 2046. The newly passed reforms will thus bring France more into line with other European countries.

All hands on deck

To accommodate the shift in demographics, there is a need for a real change in attitude from all stakeholders. In the first instance, it is important for the government to address the issue of employment of the over fifties.The employment rate in France for the 55-64 age bracket is just 38.9%compared to the European average of 46%. In reality, French people stop working on average at 58 which effectively deprives the retirement system from their potential contributions. The anomaly however is that they do not actually retire at that age; they are usually made redundant. As such, a significant proportion of French people claiming their pension for the first time are effectively unemployed.

It is important that both private and public employers adapt the work environment in order to facilitate the integration of older workers, invest in training, and make changes in production processes so as to have more ergonomic production lines.

Another solution is to do away with incentives that subsidize early withdrawal from working life whilst at the same time aligning the mandatory pension contribution periods for workers in the public sector with those in the private sector. Such a move could prove to be a contentious issue. The social security pension for private sector workers in France is calculated on the average of their ‘best’ 25 years of salaries. In comparison, public workers retirement is calculated on their ‘last six months’ of salary, which is a much more favorable proposition.

The government’s new retirement policy is designed to reduce benefit dependency. For their part, workers need to understand that early retirement is not a right, and that, unless they can afford otherwise, they must get used to working over a longer term. Public pensions for workers entering the labor market today will be significantly lower than those offered to their parents and grandparents. Voluntary, private provision for old age will also be needed to maintain future living standards.

Turning-circle manoeuvres

Pension reform has to be credible both economically and politically; markets need to be convinced by the nuts and bolts of the government’s economic policy. France currently shares the same high credit rating as Germany in terms of government borrowings, which reflects confidence in Sarkozy’s action on pushing through reforms and trimming the budget deficit.

But the issues at stake for the French government are not just solely about numbers; they are also about strategy and how to deal with a much wider political problem that the pension reform has posed. Deficit levels and how to service them are important; there are also other factors that come into the equation such as employment levels and how much pain the public can endure before they bite back. The reform measures will have a negative impact on public spending power; President Sarkozy may not just be ‘cutting his own cloth’, but that of consumer demand as well. In order to bring the people along with it, the government has therefore to convince the masses that they have a shared vision of a better road ahead.

With indicators suggesting that economic growth this year will struggle to reach 2%, the OECD is showing signs of nerves. Although pensions are indeed liabilities of the future, the timing of pension reform cannot be conditional on how the economy fares. When setting policy there are a broad range of elements in the mix, including workers, employers, unions, the bond markets, the IMF and voters. Policy making is often a balancing act wherein the platform underfoot is always moving while the balls are being juggled in the air.

Government decisions on pension policy are a reflection on the ideology of the party in power. Of course no particular ideology has all the answers; reform will always lead to heated debate and can result in street protests that may force the hand of government. It is therefore important to have a strong government in office. Fortunately, Mr. Sarkozy’s ruling UMP party has a majority in the French Assembly. To an extent they are taking a gamble in forcing through such a significant piece of legislation in the run-up to the 2012 presidential election. However, the government views structural reform as being essential to France’s longer-term economic prospects and fiscal solvency.

Given the various challenges that lie ahead, it may not all be plain sailing for the government; any ‘headwinds’ need to be met with a degree of nimbleness on the part of the policy makers. However, by undertaking this task now, the anticipated political hurricane may be downgraded to a tropical storm in time for the election.

About Des Cooney

Des Cooney is a renowned International Pensions expert with over 27 years experience in pension and wealth management. His main specialty is in the transfer of UK pensions to QROPS and International SIPPs.

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